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What is arbitrage?

 

Short Description: Arbitrage involves simultaneously buying and selling a security at two different prices in two different markets, with the aim of making a profit without the risk of prices fluctuating.

All You Need to Know About Arbitrage

Today’s financial markets are interconnected like never before. Investors can buy and sell financial instruments all over the world, literally in a matter of seconds, using a laptop with internet access and a brokerage account. Wouldn’t it be attractive if you could buy a stock or currency cheap in one market, and sell it on another market at a higher price than you purchased it for?

Theoretically, this is possible and is called “arbitrage” – a risk-free way to make a profit.

What is Arbitrage in Finance?

Arbitrage is the process of simultaneously buying and selling a financial instrument on different markets, in order to make a profit from an imbalance in price. An arbitrageur would look for differences in price of the same financial instruments in different markets, buy the instrument on the market with the lower price, and simultaneously sell it on the other market which bids a higher price for the traded instrument.

Since arbitrage is a completely risk-free investment strategy, any imbalances in price are usually short-lived as they are quickly discovered by powerful computers and trading algorithms.

Types of Arbitrage

While arbitrage usually refers to trading opportunities in financial markets, there are also other types of arbitrage opportunities covering other tradeable markets. Those include risk arbitrage, retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage.

  • Risk arbitrage – This type of arbitrage is also called merger arbitrage, as it involves the buying of stocks in the process of a merger & acquisition. Risk arbitrage is a popular strategy among hedge funds, which buy the target’s stocks and short-sell the stocks of the acquirer.
  • Retail arbitrage – Just like on financial markets, arbitrage can also be performed with usual retail products from your favourite supermarket. Take a look at eBay for example, and you’ll find hundreds of products bought in China and sold online at a higher price on a different market.
  • Convertible arbitrage – Another popular arbitrage strategy, convertible arbitrage involves buying a convertible security and short-selling its underlying stock.
  • Negative arbitrage – Negative arbitrage refers to the opportunity lost when the interest rate that a borrower pays on its debt (a bond issuer, for example) is higher than the interest rate at which those funds are invested.
  • Statistical arbitrage – Also known as stat arb, is an arbitrage technique that involves complex statistical models to find trading opportunities among financial instruments with different market prices. Those models are usually based on mean-reverting strategies and require significant computational power.

Does Arbitrage Exist in Retail Trading?

While retail traders could theoretically take advantage of financial instruments that are priced differently across brokers, it’s practically very hard to achieve. The large competition among retail brokers ensures that their price-quotes are almost the same, and many brokers actually discourage and restrict arbitrage trades. Furthermore, if you take transactions costs (spreads) into account, arbitrage opportunities in the retail trading industry are almost non-existent.

Example of an Arbitrage Trade

Complex trading concepts are best explained by examples.

Let’s say a stock of Company XY trades at $40 on the London Stock Exchange. An arbitrageur finds that the same stock is trading at $40.80 at the New York Stock Exchange (NYSE). The trader could simply buy the stock at LSE and sell it at NYSE for a profit of $0.80 per stock.

Since our investor is probably not the only one who has spotted the difference in price and the risk-free trading opportunity (in fact, hedge funds and sophisticated arbitrage software would probably be in the trade immediately as the price difference reveals), the increased demand for the lower priced stock would push its price higher in London, and similarly, the increased supply in New York would push the price of the higher-priced stock down.

Currencies are also a popular instrument for arbitrage opportunities. Unlike the stock market, currencies are not traded on centralised exchanges but on over-the-counter markets around the world, making currency arbitrage a popular way to profit on their exchange rate differences.

Investing in an Arbitrage Fund

Even as arbitrage opportunities are not easily exploited, investors can take advantage of arbitrage funds that try to profit on price imbalances between the stock and futures market. In addition, investors who want to learn more about how to find arbitrage opportunities themselves may take a look at the Arbitrage Pricing Theory (APT), developed by Stephen Ross in 1976.

 

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